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Tuesday, July 21, 2009

The key to a good magic trick is the art of misdirection. If I can get you to focus on this hand over here, then I can perform something else over here - a sleight of hand, if you will. A clever Keynesian will give you what seems to be a correct premise and then try to pull the wool over your eyes in the conclusion.

This sleight of hand emerges, for instance, when Paul Krugman argues that consumer spending causes the economy to grow. If you read Krugman for very long, you will notice that consumer (or government) spending is his holy grail. Spending is always in the back of his mind. Keynesians begin their argument with the definition of gross domestic product (GDP), which is in the form of an equation:

What is the Keynesian conclusion based on this equation? "If you increase consumer consumption or maybe even government expenditures from an 800 billion dollar spending bill, you will increase GDP." That makes sense, right? If you add to one side of the equation, then the other side must increase equally.

So you are probably thinking that Keynesians have discovered the secret to economic prosperity, right? Not so fast. What if one of the variables on the right side (such as investment) decreased in equal proportion to the increase in spending? The equation would still hold true without an increase in GDP on the left side. Here's another scenario: What if investment decreases more than the other variables increase? Then you have negative growth, and a decrease in GDP. That would be counter-productive.

Maybe one day, even in the mainstream, the Keynesian fallacy will be put to rest for good.